How Crude Oil is priced?

The collapse of the OPEC administered pricing system in 1986-1988 ushered in a new era in oil pricing in which the power to set oil prices shifted from OPEC to the so called “market”. This system was first adopted by the Mexican national oil company PEMEX in 1986. Soon, it received wide acceptance among most oil-exporting countries and by 1988 it became and still is the main method for pricing crude oil in international trade. The reasons which led to development of market related pricing of the oil prices are as follows:

• The frequent waves of protests and political crises led to disruption supplies to multinational oil companies
• OPEC oil production reduced and emergence of many suppliers outside OPEC
• Development of a complex structure of interlinked oil markets which consists of spot and also physical forwards, futures, options and other derivative markets referred to as paper markets
• Technological innovations that made electronic trading possible allowing 24-hour trading from any place in the world. It also gave rise to new market participants and allowed the development of a large number of trading instruments both on regulated exchanges and over the counter.

The current reference, or pricing markers, is Brent, WTI, and Dubai/Oman. The oil price reporting agencies (PRAs) are an important component of the oil industry. The prices that these agencies identify or assess underlie the basis of long-term contracts; spot market transactions, futures markets contracts and derivatives instruments. PRAs use a wide variety of methods to identify the oil price which may include the volume weighted average system, low and high deals done, and market-on-close (MOC).

On the onset of the Global Financial Crisis in 2008, there was a dramatic rise in the prices of crude oil to as high as $148/bbl the international market. This was followed by an equally dramatic fall. This posed a challenge to the economy of oil importing countries including India.